The Effect of Insider Control and Global Benchmarks on Chinese Executive Compensation

• Author: Weian Li,Jean J. Chen,Xuguang Liu
• Published date: 01 March 2010
• Date: 01 March 2010
• DOI: http://doi.org/10.1111/j.1467-8683.2010.00788.x

The Effect of Insider Control and Global

Benchmarks on Chinese Executive

Compensationcorg_788107..123

Jean J. Chen*, Xuguang Liu, and Weian Li

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: We investigate the effect of insider control from the managerial power perspective and the global

pay benchmarks from the behavioral approach on Chinese executive compensation.

Research Findings: Based on a balanced panel sample of 502 Chinese listed f‌irms between 2001 and 2006, we f‌ind that both

CEO duality and CEO ownership exert signif‌icant inf‌luence on Chinese executive compensation contracting and they

contribute to the high level of executive compensation. We support the managerial power hypothesis by arguing that CEO

duality and CEO shareholding tend to entrench insider managers further to collude with government off‌icials and extract

a f‌irm’s assets. Shareholdings appear to actively restrain managers from serving their self-interests as to their pay levels,

including on the board independence and the supervisory board levels. However, private institutional shareholdings

perform actively in restraining managerial inf‌luence on the executive pay setting. There is an upward increase in the

executive pay levels due to the global pay benchmark effects introduced by foreign investment. The compensation com-

mittees’ decisions on executive pay levels are largely inf‌luenced by the global peer group’s pay levels, rather than linking

to f‌irm performance as predicted by the optimal contracting model.

Theoretical Implications: We extend the optimal contracting model by incorporating the managerial power hypothesis to

demonstrate how insider control affects the Chinese executive pay setting. We also add a behavioral approach to ref‌lect how

the global pay benchmarks affect the Chinese executive compensation setting via the negotiation between a f‌irm’s com-

pensation committee and its managers.

Practitioner/Policy Implications: The Chinese government should consider exerting rigorous restrictions on executive

shareholding and management buy-out as an incentive for managers. In addition, the Chinese Code of Corporate Gover-

nance should explicitly restrict CEO duality. The government should be aware of the potential inf‌luence of behavioral bias

in human decisions departing from rational economical criteria, and set policies to balance the benef‌its of introduction of

foreign investment against the costs of resultant excessive executive compensation, and the benef‌its of setting a compen-

sation committee as a corporate governance control device against the costs of the compensation committees working with

the executives together to increase the executive pay level.

Keywords: Corporate Governance, Executive Compensation, Benchmark Effect, Managerial Power, China

INTRODUCTION

The argument about and censure of executive compen-

sation has been a popular sport among business

pundits for decades due to transparency requirements and

human envy (Jensen, Murphy, & Wruck, 2004). This wide-

spread interest in executive pay has been inevitably fuelled

by the recent global f‌inancial crisis when top executives

received escalated compensation in contrast to the falling

company stock price and spreading employee layoff. The

deviation of executive compensation fromf‌irm performance

is still the center of debate. China is not an exception where

executive compensation has escalated dramatically in recent

years while individual investors in the Chinese stock

*Address for correspondence: University of Surrey,School of Management, Guildford,

Surrey, GU2 7XH, UK. Tel: +44 (0) 1483 689668; Fax: +44 (0) 1483 686346; E-mail:

j.j.chen@surrey.ac.uk

107

Corporate Governance: An International Review, 2010, 18(2): 107–123

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00788.x

markets have suffered losses and employees have been

made redundant under the shock wave of world economic

recession since 2008.

Originating from an egalitarian wage system in a former

planning economy, Chinese executive compensation has

been largely inf‌luenced by China’smarket-oriented reforms,

global governance convergence, and the introduction of

foreign investment. In this paper,we investigate the effect of

insider control from the managerial power perspective and

the effect of global pay benchmarks from the behavioral

approach on Chinese executive compensation. Theoretically,

we are motivated by the departures of pay practices from the

predictions of the optimal compensation-contracting model

based on agency theory. Most extant theoretical frameworks

on executive compensation have been rooted in the agency

theory under moral hazard and drawn general conclusions

about the determinants of executive compensation (Becht,

Bolton, & Röell, 2003). In a principle-agent framework, man-

agers are subject to an agency problem and do not always

work towards maximizing shareholder value (Shleifer &

Vishny, 1997). This agency problem arises from the diver-

gent goals between shareholders (principals) and managers

(agents) as well as the unobservable behavior of managers

for shareholders to verify. The agency theory focuses on the

optimal contract governing the principal agent relationship

(Eisenhardt, 1989). The objectives of the optimal contracting

model are to align divergent interests between shareholders

and managers (Jensen & Murphy, 1990) and provide infor-

mative performance measures (Hölmstrom, 1979), under the

assumptions of arms-length contracting and unbiased ratio-

nal decision making.

However, the departure of real world pay practices from

the predictions of optimal contracting model imply that the

optimal contracting model under the agency theory alone

cannot adequately explain the complex aspects of compen-

sation arrangements (Edmans & Gabaix, 2009). For example,

the generally observed low pay-performance sensitivities

(Jensen & Murphy,1990) and the weak explanatory power of

performance on CEO pay (Tosi, Werner, Katz, & Gomez–

mejia, 2000) may raise suspicions as to the role of pay-for-

interests alignment, while the less supportive evidence on

relative performance evaluation originating from the infor-

mativeness principle and rewarding CEOs for luck (Ber-

trand & Mullainathan, 2001) imply that the design of

compensation schemes is inf‌luenced by executives as partof

the agency problem itself (Bebchuk & Fried, 2003).

Another weakness imbedded in the optimal contracting

model is that the model does not have suff‌icient references

to institutional details, even though there is a great deal of

heterogeneity in pay practices across f‌irms, industries, and

countries over time (Murphy, 1999). These weaknesses are

largely because the optimal contracting theory is developed

from the US setting, which shares the same Anglo–

American institution arrangements. Therefore, it suffers

from limitations when it is applied to China. China has a

different institutional environment characterized by weak

shareholder protection and the lack of a market for corpo-

rate control. Chinese listed f‌irms are characterized by a con-

centrated state ownership structure, insider control, and

large private benef‌its for company insiders (Aoki, 1994;

Chen, 2005; Firth, Fung, & Rui, 2006, 2007). Bruce, Buck, and

Main (2005) argue that the dominance of agent theory as an

approach to investigate executive pay has led to an overly

narrow focus that is unhelpful when considering cross-

country differences.

As a result, recent literature starts to address the issue of

executive compensation in developed markets from the

managerial power perspective and challenge the arm’s

length contracting proposed by agency theory (Bebchuk,

Fried, & Walker, 2002). However, existing literature on

Chinese executive compensation still limited to the optimal

contracting model and concentrated on pay as a reward for

either accounting performance (Firth et al., 2006) or stock

performance (Kato & Long, 2006). Therefore, the two weak-

nesses of optimal contracting theory that we discussed build

on those studies. It may not be surprising that the pay-for-

interests alignment prediction in the Chinese context suffers

from mixed evidence of pay-performance sensitivity (Firth

et al., 2007; Kato & Long, 2006), and there is little use of

relative performance evaluation (Mengistae & Xu, 2004).

In addition to the lack of consideration of local institu-

tions, the unbiased decision making assumptions in optimal

contracting model also underestimate behavioral elements

in pay setting process, such as peer group reference points,

cross country comparison, and the up-biased benchmark

effect (Devers, Cannella, Reilly, & Yoder, 2007; Ezzamel &

Watson, 1998; O’Reilly & Main, 2007). These behavioral ele-

ments are particularly important to China, which aims to

emulate the global corporate governance practice and pay

level introduced by foreign investment in China.

Motivated by these gaps in the literature, in this study we

f‌irstly extend the optimal contracting model by incorporat-

ing the managerial power approach to demonstrate how

insider’s control problem affects the Chinese executive pay

setting. In particular, we def‌ine the managerial power in

China by the power source and governance constraints that

Chinese managers face under the government intervention

and state controlling ownership. This power def‌inition is

different from that in the Anglo–American dispersed own-

ership settings. Secondly, we add the behavioral approach to

the optimal contracting theory in order to ref‌lect how the

global pay benchmarks inf‌luence the Chinese executive pay

setting via the negotiation between a f‌irm’s compensation

committee and its managers.

Methodologically, we make two contributions to the

extant literature on Chinese executive compensation.

Firstly, the extant literature on Chinese executive compen-

sation suffers from the shortcomings of a cross sectional

analysis (Devers et al., 2007; Firth et al., 2006; Li, Moshir-

ian, Nguyen, & Tan, 2007). We improve the existing meth-

odology by adopting a panel analysis. Our panel data set

enables us to control the potential biased problem caused

by unobservable individual and time effects, which is par-

ticularly important for China given the information disclo-

sure limitations. Secondly, we use lagged value for all the

independent variables to control for the endogenous

concern in empirical corporate governance research (Coles,

Lemmon, & Meschke, 2003; Devers et al., 2007; Hermalin &

Weisbach, 2003), especially the timeframe problems in the

determination of compensation.

Our f‌indings show that both CEO duality and CEO own-

ership exert signif‌icant inf‌luence on the Chinese compensa-

108 CORPORATE GOVERNANCE

Volume 18 Number 2 March 2010 © 2010 Blackwell Publishing Ltd